Capital budgeting is the process of evaluating, comparing and selecting capital projects to achieve the best return on investment over time. It focuses on capital expenditures and specifically the analysis of capital expenditures to decide which capital expenditures should be made. It is an important factor in the success or failure of an organization since investments in fixed assets affect the financial health of an organization for many years. This report aims to apply investment appraisal techniques and critically analyse the possible investment options of Abkaber Technologies Company (ATC), a listed company based in Europe which is involved in the manufacturing of motor vehicle parts.
Literature Review
Capital budgeting decisions are among the most important decisions made by business entities. Organizations have patterns that guide how investment opportunities are identified and how investments are made. During capital budgeting processes, investments compete for corporate resources and some projects survive the intrinsic selection process while others don't. (Kersyte, 2011)
According to Brown, et al., (2010), capital budgeting is the process for analysing the capital expenditures of an organization. The process involves identifying the initial cost of the project, determining the incremental cash flows resulting from the implementation of the project, analysing the project with one of five capital budgeting methods and performing a post audit analysis.
Ducai (2009), advises that the process approach to capital budgeting endorses broader perspectives ateempting to explain the way companies actually handle into effect the investment decisions, the way the investment opportunities are identified and analyzed, the way decisions are made and the way the rate of return on investments are evaluated.
Significance of Capital Budgeting
Capital budgeting decisions are crucial to a firm's success for several reasons. Because capital budgeting decisions impact the firm for several years, they must be cautiously planned. A bad decision can have a significant effect on the firm's future operations.
Capital expenditures typically require large outlays of funds and it is important that firms ascertain the best way to raise and repay these funds. When large amounts of funds are raised, firms must pay close attention to the financial markets because the cost of capital is directly related to the current interest rate.
Additionally, most capital budgeting decisions require a long term commitment therefore, the timing of the decisions is important. Many capital budgeting projects take years to implement. (Cooper, et al., 2001)
Important Capital Budgeting Concepts
Weighted Average Cost of Capital (WACC)
asset, equity and cost of equity.
Specific cost of capital
Capital Budgeting Process:
Proposal Generation
This is considered one of the most important steps because it is the origination of proposed capital projects for the firm by individuals at various organizational levels based on the needs and experiences of the organization.
Review and Analysis
This is the formal process of assessing the relevance and economic viability of the proposed project in relation to the firms overall objectives. This is conducted by estimating cash flows arising from the project and evaluating them through capital budgeting techniques. Risk factors are also incorporated into the analysis phase.
Decision Making
Decision making is the step where the proposal is compared against the predetermined criteria and either accepted or rejected.
Implementation and Follow-Up
Implementation of the project begins after the project has been accepted and funding is made available. Follow up is the post implementation audit of expected and actual costs and revenues generated from the project to determine if the return meets projections. Post audit analysis allows managers to make improvements to the firms forecasting techniques.
Appraisal Techniques
There are five most commonly used appraisal techniques and these are; Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, Average Accounting Rate of Return (AAR) and Profitability Index (PI).
The most commonly used appraisal technique for assessing the value of a long term project is Net Present Value (NPV) or discounted cash flow. NPV is the summation of the present value of all the cash inflows and outflows from the development and production phases of a project. An NPV greater than zero implies an actual rate of return on the investment that is greater than the discount rate used, the minimum acceptable rate of return that must be earned by a capital expenditure. (Crill, et al., 2006)
In this report, we use the Weighted Average Cost of Capital (WACC) as the discount rate. The WACC is determined by averaging all of the capital costs acquired by an organization. It is more applicable as a discount rate in capital budgeting because it uses the after tax costs of resources and it allows the organization to know what rate of return it much attain to satisfy the needs of creditors and stockholders.
The asset beta, equity beat and cost of equity were used to calculate the WACC.
Beta is assumed to be zero
Call Option and put option model
Black scholes
Report to Board of Directors
